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Health Care Costs: A Market-Theoretic View

November 2, 2009 at 4:00 am

Austin Frakt

Health reform, even with a public option, will be built largely on a private insurer infrastructure. That means hundreds of billions of dollars will be pumped through insurance companies on their way to payment to providers for health care services. Given this reality, we should all want as efficient a health insurance market as possible.

This appears to be the beginning of an argument for encouraging additional competition among health insurers. Greater competition is the source of greater market efficiency, isn’t it? The answer is, it depends on the market. The simple type of idealized market taught in Econ 101 does become more efficient (in an economic welfare sense) as competition increases. But other types of markets–in particular, so called two-sided markets, among others–do not always behave this way. And health care is one of them.

Let’s first consider the best-case scenario for the consequences of greater competition in the health insurance market. About 85% of insurers’ costs are medical. The remaining 15% is for administration, marketing, management, and profit (profit itself is about 6% at the time of this writing). With additional competitive pressure insurers would compete away some of that 15%. Perfect competition would reduce profit to zero and may force efficiencies elsewhere. So, perhaps the best competition could do would be to cut in half that 15% for administration, marketing, management, and profit.

Figure 1

Now a 7.5% reduction is not chump change. It represents a lot of money, tens of billions of dollars annually. But that’s only an optimistic best case. And it pales in comparison to the cost savings that are available on the provider side, the 85% of insurers’ costs. (Hat tip: Michael Chernew.)

If we really wish to understand what would happen if the insurance market is made more competitive we have to go one step further. There is a reason the health care market is not analyzed in Econ 101. It is much more complex than, say, the market for coffee. In fact, additional competition in the health insurance market could drive costs up. Here’s a a graphical depiction of what I have in mind.

Figure 2

The figure is drawn for a fixed level of provider market concentration. The horizontal axis is insurer market concentration, and the vertical axis is premium for a standardized plan. Relative to the fixed level of provider concentration, insurer concentration is high in the region of point “C,” and premiums are above the minimum possible level. Insurers are charging above the competitive premium level because they have excessive market power. In this region, higher premiums stem from higher insurer profits and/or lack of administrative efficiency (the red zone of Figure 1).

On the other hand, insurer concentration is low relative to that of providers in the region of point “A,” and premiums are again above the minimum because insurers can’t negotiate down to the lowest possible price with providers. Providers have too much power relative to insurers and are charging prices above the competitive minimum. Insurers pass those high prices onto consumers through higher premiums. In this case, higher premiums stem from higher medical costs (the green zone of Figure 1).

As provider power weakens the whole curve shifts downward, and as provider concentration increases the whole curve shifts upward.

If we’re now at point “C” (and this is by no means certain) it may be possible to achieve lower premiums by diluting the insurance market, weakening insurers with respect to providers. But if we go too far, we’ll shoot past the optimum “B” and be no better off. On the other hand, if we’re now at point “B” we should do nothing to upset the insurer-provider balance of power. And if we’re at point “A” then it is the provider market, not the insurance market, that has excess concentration.

As far as I know, nobody knows which of the many local health care markets are operating at “A”, “B”, or “C.” In fact, I have not yet seen any studies that can tell us what mix of insurer-provider market structure achieves the optimal point “B.”

It is worth noting that what is being considered in Washington as the long-term solution to health care costs has less to do with finding an optimal mix of insurer-provider power and more to do a change in the incentives of provider payment. The goal is to shift the entire curve in the figure above downward so that in every type of market–“A,” “B,” and “C”–health care costs and premiums come down. But a downward shift due to payment reform may be offset by a movement leftward along the curve. Such an offsetting effect could be brought about by antitrust action against insurers, weakening their market power with respect to providers. A similar offset could occur through additional integration of providers under a payment reform model (ACOs, CHTs). Both of these potential offsets are included in current legislation.

There is more to say about health care costs from a market theory point of view. I will be returning to this issue and referring to Figure 2 in the near future. The bottom line, however, is that the failure of policymakers to consider the insurer-provider balance of power may prove to be a costly oversight.

I am not a policy wonk or professional economist by any means but I do not understand how increased competition in the form of a public option (if that could be considered fair competition) could cut your Profit, Admin, Management number from 15% to 7.5%. Perfect competition would imply margins with zero monopoly rents but still would include a market cost of capital. The regulated electrical utilities have net margins in the 6-10% range after tax and that might be a reasonable comparison for a cost of capital figure in a highly regulated industry like healthcare. The current after tax margins for the big manager care companies is more in 4% range. Furthermore, you do not include an underwriting risk premium in your margin. The government numbers for Medicare operating costs touted by politicians don’t include any risk premium or cost of capital but show costs show up in the top line numbers that the taxpayers must cover.

I would be much more concerned about saving in the 85% provider area. As far as I can see, in the cities that I have visited lately, there are lots of new or newly renovated shiny hospitals and outpatient surgery centers. Most doctors in private practice who perform surgery and other medically intensive procedures at hospitals can charge monopoly rents for their service while using hospital resources for free. Doctors also get together and build outpatient surgery centers and that undercut the local hospitals but use the local hospitals emergency rooms as backup if something goes wrong. It is generally accepted that reduced reimbursements for doctors is a bad thing but maybe it is a good thing for the public. Primary care is the only area where there is any significant competition among the physician credentialing organizations. Isn’t this what competition is supposed to do?

My direct experience in the information systems world is that most doctors do not have any incentives to implement new technologies or processes to improve care unless that investment can be directly tied to a billable procedure, i.e. a sonogram machine. Doctors do not invest in technology that would allow them to offer a coordinated care approach that would do the most to increase efficiency and improve quality and outcomes. They have no economic incentive to do so. Furthermore, most private practices are single specialty practices with each doctor operating relatively independently in terms of patient care decision-making. This doesn’t lend itself to coordinated and efficient care of the larger clinical models like Mayo. I, as a consumer, would pay a premium to go to a practice that truly offers a coordinate care approach. But then consumer information about physician rates and quality outcomes is extremely difficult to come by.

I recently jumped up and down and started yelling Hallelujah when my new primary doctor entered a prescription and electronically transmitted it to my pharmacy. He thought I was going crazy until I told him that this was the first time any doctor had done so for me. Most of the large auto body shops have much more sophisticated management and records systems than doctors do. How will a public option that reimburses provider at close to Medicare rates make it easier for private insurers to impose lower rates and more efficiency upon providers? I don’t get it.

@Roger – I’m happy to reduce my upper bound on cost benefits of competition from 7.5% to your best (and lower) guess. That only strengthens the argument. As this is not central there is no point in debating it.

Insurer margins are on the low side right now and I don’t know how you think a company can have 4-6% margins after tax and then run the whole operation for 3.5% of revenues for 7.5%. You may think Medicare is doing this but they are not.

You also have to consider that corporate taxes are included in insurer’s 15 percent SGA&Profit number. Futhermore, i don’t know how policy maker think that the can impose regulation to micromanage a market at expect more insurers to enter it. I would think that deregulating the market and allow more to happen across state lines would increase competition. There are enormous costs to insurer to be licensed and meet all the different state requirements. Additionally many politicians get confused between the effects of competition and increasing the size of risk pool for the individual and small business market.

@Roger – You seem to want to argue about the 15% or the 7.5%. That’s entirely beside the point.

As for the relationship between regulation and entry, think Medicare Part D. Very regulated. 50+ plans per market.

But your points are well taken. My meta-point, mostly, is that there is a big picture and provider concentration relative to that of insurers matters. Health care costs are (mostly) not a health insurer issue.

I think you’re using the wrong reference for the profit margin and thereby greatly understating it. Consider if I self-insure and pay the insurer to administer. I am spending $85 on actual medical costs and $15 to the insurer for administering for me and paying the medical providers.. $6 of the $15 is profit? That’s a margin of 40%, or a markup of 67% ($6 profit over $9 operating cost.)

If the insurer is doing the insuring, there is some added risk of actual payouts being higher or lower, and this is in part offset by a return on investing the fees. (Premiums are paid up front and expenses paid later.) If 6% of premiums is profit, I would expect the return on capital to be much higher than 6%, since the capital is associated with the 15% administration cost, and not the total premium amount. (Note: The medical providers’ profits are already included in that 85%.)

This reminds me of Enron claiming billions of dollars in revenues for trades that they administered, when their actual revenues were just a few percent of those billions of dollars of trades.

@Glenn Cassidy – I see that my original citation to 6% profit is broken. But trust me, that was the figure that was in the news at the time I wrote this post. Here is another source that suggests insurer profits are not above that level. But if what you say is right about the base for that figure, then I’m wrong to say that we might, at best, cut the 15% of the insurer’s costs/profit in half. If reducing the profit to zero will only cut that 15% by 6% then that’s considerably less savings than I had indicated. That only strengthens my point. The real money is at the provider end.